Started off as a blog about the irregularities in the nomination of the ECB President. Documents abuse of the public trust in the domain of economic and monetary affairs.

Sunday, July 29, 2012

Sorkin and Pearlstein share the wrong view of Glass-Steagall

Sorkin writes 'reinstating old rules [Glass-Steagall] not a solution' (Dealbook). The Washington Post publishes an article by Steven Pearlstein in the same vein: 'Let's shatter the myth on Glass Steagall' (WP). Both Sorkin and Pearlstein are recipient of prestigious awards (Gerald Loeb and Pulitzer).

This post debunks the fallacies of both articles. Misguided reasoning

The method of Sorkin and Pearlstein is to look at specific institutions—Lehman, JP Morgan etc.—that either failed or didn't and reason that Glass-Steagall wouldn't have helped or was unnecessary. For example:

The infamous AIG? An insurance firm. New Century Financial? A real estate investment trust. No Glass-Steagall there—Pearlstein

This exercise is futile because the nature of a system is not revealed by studying its local components. Pearlstein's other approach is to point to alternate phenomena, macro imbalances, the development of shadow banking, consolidation, complexity etc. as more probable causes of the crisis. This also misses the point and they both rely in many cases on distorted facts or half truths.

The activities of banking, no matter how complex, essentially boil down to borrowing and lending and payment transfers. Think of institutions as nodes in a network in which transactions between them form the connections. Such a system is too complex to forecast or control. The idea of Glass-Steagall is to carve out a sub-network—call it commercial banking, constrain its complexity, and keep its dependency to the the rest of the network—call it investment banking—low. In doing so, the sub-network is supposed to become more robust and behave in a more predictable way than the fusion of commercial and investment banking, a.k.a one-stop-shop-banking or (in Europe) universal banking.

Public utility

If your town is evacuated to flee a disaster, you bring with you what is most essential to your livelihood during and in the aftermath of the crisis, knowing the disaster could destroy what you leave behind. It's the same principle with Glass-Steagall. One puts in commercial banking, in terms of type of activities and group of clients, only what is most essential for the survival of the system, put safeguards around it and vouch to rescue it if necessary. Being able to use your credit card and cashing your salary check come at the top of the list of activities to protect.

Take this paragraph from Pearlstein:

The evidence is now overwhelming that top executives and directors and regulators are often clueless about risks deliberately taken and corners knowingly cut by people working under their direction. The chances of that happening grow with the size and complexity of the bank.

Everyone knows this, but it's not a good reason dismiss Glass-Steagall. Provided it does indeed mitigate the contagion of risk from investment banking to commercial banking, it takes away from the former the implicit government guarantee that currently exists and whose exercise has unfortunately defined the crisis response (TARP). This guarantee, in the current system, creates an incentive for banks to take more risk that they can bear. Why do you think bank executives hire lobbies to preserve the statu quo other than for safeguarding this privilege for themselves?

To summarize, Glass-Steagall acts a public utility in that it safeguards essential infracstructure, but, at the same time suppresses Moral hazard. Targeted, rather than omnipresent, regulation.

Lehman straw man

In application of the enunciated principles, saying that Lehman, while an investment bank, had to be rescued, is a straw man argument Sorkin is not hung up on:

The
first domino to nearly topple over in the financial crisis was Bear
Stearns, an investment bank that had nothing to do with commercial
banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers;
it too was an investment bank with no commercial banking business and
therefore wouldn’t have been covered by Glass-Steagall either. [etc.]

The relevant questions are: a) would the likelihood of a Lehman moment have been the same under G/S and, b) if it strikes, what the implications would have been for pure commercial banks? The answer to a) is no, because there would have been less moral hazard (see above).

When the government guarantee is strictly confined to commercial
banking, the incentive for greater risk within is offset by strict (by requirement) and enforceable (thanks to reduced complexity)
regulation. That includes limits on wholesale funding which is the first
channel of contagion in a liquidity crisis as exemplified in the fall of Lehman. The answer to b), therefore, is 'lesser implications'.

In the abstract, the argument for Glass-Steagall is strong: regulate the segment of banking that is most critical for day to day business as a utility and protect it as such. The devil, of course, is in the detail of the implementation. Sorkin and Pearlstein should have focused their attention on that.

Detail, however, is not more their forte than method. Pearlstein says that 'Wachovia and Washington Mutual, got into trouble the old-fashioned way – largely by making risky loans to homeowners'. In the words of Sorkin:

Now let’s look at the major commercial banks that ran into trouble. Let’s first take Bank of America. Its biggest problems stemmed [...] from its acquisition of Countrywide Financial, the subprime lender, which made a lot of bad loans — completely permissible under Glass-Steagall. [and likewise for Wachovia]

Sorkin and Pearlstein equate Glass-Steagall with separation of commercial and investment banking, an aspect that was repealed in 1999. However, under the original legislation, mortgage lenders couldn't have packaged the loans into securities they then sold. The 1984 SMMEA made that possible.

More generally, Glass-Steagall was dismantled and negated by a series of legislative acts. Sorkin and Pearlstein haven't carefully studied the legislative history surrounding Glass-Steagall. They just throw dirt at the wall hoping some will stick.

Half truths and distorted facts

According to Pearlstein, JP Morgan could have weathered the crisis without TARP. That's what Dimon would have us believe. Besides, JP M allegedly eased its way through the crisis by manipulating LIBOR, which is equivalent to a fraudulent subsidy. No mention of that is deceit. Even if JP M was forced to take the money, that's because the giving party thought it needed it. Why give Dimon precedence over the US Treasury? Citibank, which is also a one stop shop bank (and notoriously opaque at that), isn't cited, whereas it also received TARP money in the hundreds of Bns. Selective omission.

Pearlstein points to mass bank failures that occurred prior to the repeal of Glass-Steagall in 1999. The internet bubble and the GFC which occurred during 2000-2010 mark a significant increase in systemic risk. Whether one takes the view that the repeal was irrelevant or an aggravating factor, based on this, is a conjecture. Still, the empirical evidence favors the second hypothesis.

Sorkin and Pearlstein haven't risen to the challenge on this topic; they are complacent. Admittedly, it's a deep issue, and arguments from both sides need to be confronted much more rigorously.

Also see

Both 'modularity'—as opposed to TBTF— and 'circuit breakers', such as
separation of commercial and investment banking, are supported by a significant
study in the global systemic collapse realized by a physicist (ZeroHedge).